Legal issues

Considering CRTs

Charitable remainder trusts are an exit option for commercial property owners.

In recent years, many of my clients have relayed the same situation as they approach retirement age: They bought an investment property 20 or 30 years ago that has appreciated beyond their wildest dreams. But that’s where the good news ends. Now that they are older or possibly even retired, they’ve lost interest in continuing to manage the property. And, since many retirees are on fixed incomes, the financial burden of maintaining and repairing an investment property is more than they can comfortably afford. Many clients would like to sell their investment properties and start enjoying their substantial profits.

However, selling highly appreciated investment property can be tricky. The combined federal and state capital gains rates can be as high as 30 percent on investment property sales, which represents a large portion of the capital retirees may want to reinvest to enhance their fixed retirement income. Many advisers suggest their clients sell their investments and complete a Section 1031 tax-deferred exchange. This can be a good strategy, but it puts clients back into owning property, which many times is not the objective.

Clients who want to retain the power of their equity and avoid capital gains taxes should consider creating a charitable remainder trust. A specific advantage is that CRTs can be established with an annual payout of 5 percent or more for the duration of the client’s life. When a property is deeded to a CRT, donors receive a significant income tax deduction -- 29 percent of the asset’s value if both spouses are age 65, 36 percent if both are age 70, and 44 percent if both are age 75. The deduction can be taken in the year the trust is funded or spread out over six years to offset as much as 30 percent of their adjusted gross income for each of those six years. In addition, the investor’s designated charity becomes the beneficiary of the trust upon the investor’s death.

For example, if a client bought an income-producing property for $200,000 and sold it 20 years later for $800,000, the potential capital gains exposure could be as high as $180,000. If the client reinvested the balance of the proceeds -- $620,000 -- at a 6 percent rate of return, the annual yield would be approximately $37,200. If the $800,000 investment property is put into a CRT, upon sale the proceeds within the CRT can be reinvested in a stock and bond portfolio so that the $800,000 principal can grow and continue to pay out at least 6 percent –- in this case $48,000 -- per year for the remainder of the donors’ lives. With the tax deduction that can be taken for the first six years of the trust’s duration, most of the income from the trust during that period can be sheltered completely.

Suppose the investors determine they’d prefer the $800,000 go to heirs, such as their children. In this situation, clients could consider buying a whole life insurance policy for $800,000 that either is owned by the children or put into a life insurance trust. The investors make annual gifts to the children or the trustee of the life insurance trust. The policy owner then uses those funds to pay the annual insurance premium. When the investor passes away, the designated charity receives the balance of the funds from the CRT and the heirs receive $800,000 tax free from the life insurance trust.

However, there is an important caveat to consider when working with CRTs: This tax-deferral structure is not suitable to property encumbered by debt. Before engaging in a CRT, investors should consult a qualified tax professional to discuss the various advantages and disadvantages of this tax-deferral strategy.

Len Jarrott, CCIM

Len Jarrott, CCIM, is president of Jarrott & Co. Real Estate Investments in Santa Barbara, Calif. Contact him at (805) 569-5999 or len@jarrott.com.

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